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Should You Pay Points to Buy Down Mortgage Interest Rate?

I am currently refinancing a rental property that I own. The new loan will have a $77,000 principal balance and a 15-year amortization and term. The loan officer presented me with the following interest rate options:

3.75% with 0 points

-or-

3.25% with 1.29 points

-or-

3.0% with 2.43 points

Here is how I go about deciding whether or not to pay points to buy down the rate:

First, I need to think about some assumptions. In this case I assume that I will own the property for at least 15 years, during which time I will not refinance this loan (3-4 percent is a pretty amazing rate - I think we'll all be wondering how it was possible in 10 years!).

Next, I calculate the actual dollar cost to “buy” each rate:

3.75%: 0 points = no cost

3.25% : 1.29 points = $77,000 x .0129 = $993.30

3.0%: 2.43 points = $77,000 x .0243 = $1,871.10

I then calculate the principal and interest payment for each interest rate:

3.75%: P&I = $559.96 / month

3.25%: P&I = $541.05 / month

3.0%: P&I = $531.75 / month

Finally, I take the total annual savings of each lower interest rate and compare it with the 0 point option to determine a “rate of return” on my initial investment, the dollar cost of the points required to buy down the rate.

To make my decision, I compare the available rates of return on the points paid to my “opportunity cost of capital” or the rate of return I think I could attain on other similar investments. Since buying down an interest rate is a guaranteed (zero risk) investment - unless I were to sell the property - my opportunity cost of capital is very low, say 2-3%.

So I chose to pay 1.29 points for the 3.25% rate because the 23% rate of return exceeds my opportunity cost of capital and is higher than the 18% return offered by the 3.0% rate option.

It should be noted that if I assume I might own the property for a shorter length of time or refinance in the near future, that would change the decision making process and introduce additional variables into the decision.

What say you, fellow BP members? What other factors do you take into account? How do you go about choosing whether or not to pay points to buy down a rate?

Edit: If you don't want to read a bunch of boring calculations and just want an easy way to determine the "rate of return" on points paid to buy down an interest rate, I found this calculator. If you want to get into the weeds, continue reading at your own risk.

You bring up an important point that I had not thought of. There are tax implications involved in this decision as well.

I reviewed IRS Publication 527 and it appears that there are several ways in which the points can be amortized. For simplicity's sake, let's say that I amortize the points equally over the term of the loan.

In my initial analysis I also failed to take into account that the interest and principal amounts paid in year 1 will be different. Let's revisit the calculations:

Tax Implications

Option 1: 3.75%, no points

1st Year Interest Paid - $2,820.93

Amortized Points Deduction - $0.00

Option 2: 3.25%, 1.29 points ($993.30)

1st Year Interest Paid - $2,442.52

Amortized Points Deduction - $993.30 / 15 = $66.22

Total Interest + Points Deduction = $2508.74

Difference (Option 1 - Option 2) in IRS Deductions = $312.19

Assuming one is in the 28% tax bracket, option 2 would result in the loss of $87.41 in tax savings.

Love your analysis. The only thing I would add is if it would prevent you from being able to complete a deal. At 77k not a big deal. On the other hand I have totally taken lower IRR because it allowed me to be able to do a second one.

To make my decision, I compare the available rates of return on the points paid to my “opportunity cost of capital” or the rate of return I think I could attain on other similar investments. Since buying down an interest rate is a guaranteed (zero risk) investment - unless I were to sell the property - my opportunity cost of capital is very low, say 2-3%.

I don't think you are looking at this correctly.

Your overall cost of capital is normally divided into two parts: cost of equity, and cost of debt. Your lender will tell you your cost of debt, and most investors will tell you that their cost of equity is something in the 10-20% range. That is to say, they would only be willing to pay cash for an investment if it offers that sort of return.

This is why investors usually finance properties -- it is better to buy it with 4% money than with 10% money. A blend of equity and debt yields a lower cost of capital than equity alone. If your cost of equity was really 2-3%, you would be very opposed to any sort of financing, because it would increase the overall cost of capital on the investment.

Your opportunity cost, as a separate concept, in the words of Warren Buffett is "what can be produced by your second best opportunity". If you could apply that money towards a down payment on a property that earns you 10%, then your opportunity cost is 10%. If your return on investment for the points exceeds 10%, then pay the points. If not, pay the higher interest rate and use the money on the investment that pays you 10%.

Note that there are hoards of articles on his site about points selections, etc. too. The content generally needs to be adjusted for investors somewhat because your cost of equity should be at least in the low teens even if you're a bad real estate investor.

Great point re: "Opportunity cost of capital". I agree that term should be reserved for the rate of return that could be generated by your second best opportunity. Buffett always has a way of making things easy to understand!

I guess I wanted to give some consideration to the fact that the "rate of return" generated by buying down an interest rate is a guaranteed, zero-risk investment, assuming you keep the mortgage. Maybe a better term would have been "risk-adjusted rate of return".

Thanks for the point out on the mortgage calculator. I had linked to that as well in my second post, but if you didn't read it I don't blame you. I was really getting in the weeds. Also agree re: cost of equity.

I'm all about cash flow so I would be wondering why you would go with a 15 year fixed instead of a 30 yr fixed? You can always pay more, but you can never pay less. :)

If you take all closing costs (including the points to buy down the rate) and divide that by the amount of money you save every month (points vs. no points) you'll get a rough estimate as to how many months it will take to pay off the closing costs.

As I'm sure you know, right now there is a significant difference in rates on 15 and 30 year mortgages. I was quoted 3.75% for a 15 year or 4.625% for a 30 year with 0 points.

For the $77,000 loan above, I would pay $23,793 in interest on the 15 year note or $65,518 on a 30 year note if paid on schedule, for a difference of $41,725. I would also have a free and clear asset 15 years earlier by taking the 15 year option.

If I understand you correctly, you are asking why I wouldn't take the 30 year mortgage and pay it on a 15 year schedule. Valid argument. The 30 year note would provide some safety margin if rents fall.

For me it comes down to the spread between the 30 and 15 year interest rate. If the spread was less significant, I might consider doing exactly what you suggested.

My personal reasons for investing are more wealth-driven than income-driven, so I am comfortable locking myself into the higher payment with the knowledge that I may have to "feed the alligator" if rents fall.

I don't have all of my properties on 15 year mortgages. Actually, most of them are on 30 year mortgages. I guess in this case, the significantly lower rate on the 15 year was too good to pass up.

I know this is an old thread, but I believe there's a critical flaw in the reasoning that should be pointed out. The claim is that paying points gives you an annualized rate of return, and this return is used used to compare to other investments. For example, one rate of return is calculated like this:

The problem with this is that in most investments the rate of return is assumed to be *on top of your principal*. If I get 2% annually on a savings account, I have 1.02% of my original principal at the end of a year. This is not the case with buying points. If you pay $993 in points, that money -- your principal -- is gone. You don't end the year with 1.23% of the money you put in. You end the year with $226.92, which is -77% return on your $993.

The rate of return gets better the longer you hold on to it. In year 5 it's positive, at 2.7%. It peaks at year 12 at 8.8%, and then ticks down.

Having said that, there is even more that can go into to calculating the rate of return of points. When you have a lower interest rate, you pay off more principal faster, which increases you return when you sell. Or, if you carry the loan to term, you saved all the interested in addition to the lower payment.

Yes, thank you for sharing! When I'm advising clients, the big question is "how long do you plan on being in/holding on to the property?" If it's long term, or a forever home, then the "discount" that they pay for the rate should be justified because it is supposed to be still significantly less than what they would otherwise pay in interest over the long haul with a higher interest rate. So, if someone is going to sell the property in a few years then paying a huge fee for a rate obviously does not make financial sense.

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